1. The Monetary Policy and Aggregate Demand Curves
Mishkin/Serletis
The Economics of Money, Banking, and Financial Markets Fifth Canadian Edition
Chapter 23
The Monetary Policy and Aggregate Demand Curves

2. Learning Objectives
Understand why there is a positive relationship between real interest rates and inflation, the MP curve
Illustrate how the IS curve and the MP curve can be used to derive the aggregate demand curve featured in the aggregate demand and supply framework

3. The Bank of Canada and Monetary Policy
The Bank of Canada controls the overnight rate by varying the settlement balances (reserves) it provides to the banking system
When it provides more reserves, the excess liquidity causes the overnight rate to fall
When the Bank drains reserves from the banking system, the shortage of liquidity leads to a rise in the overnight rate

4. The Monetary Policy Curve

5. The Monetary Policy Curve
The monetary policy (MP) curve shows how monetary policy, measured by the real interest rate, reacts to the inflation rate
The MP curve is upward sloping: real interest rates rise when the inflation rate rises

6. The Taylor Principle: Why the Monetary Policy Curve Has an Upward Slope
The key reason for an upward sloping MP curve is that central banks seek to keep inflation stable
Taylor principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when rises
Schematically, if a central bank allows r to fall when rises, then:

7. Shifts in the MP Curve
Two types of monetary policy actions that affect interest rates:
Automatic (Taylor principle) changes as reflected by movements along the MP curve
Autonomous changes that shift the MP curve
autonomous tightening of monetary policy that shifts the MP curve upward (in order to reduce inflation)
autonomous easing of monetary policy that shifts the MP curve downward (in order to stimulate the economy)

8. Shifts in the Monetary Policy Curve

9. The Inflation Rate and the Overnight Interest Rate

10. The Aggregate Demand Curve
The aggregate demand curve represents the relationship between the inflation rate and aggregate demand when the goods market is in equilibrium
The aggregate demand curve is central to aggregate demand and supply analysis, which allows us to explain short-run fluctuations in both aggregate output and inflation

11. Deriving the Aggregate Demand Curve Graphically
The AD curve is derived from:
The MP curve
The IS curve
The AD curve has a downward slope: As inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fall

12. Deriving the AD Curve

13. Factors that Shift the Aggregate Demand Curve
Shifts in the IS curve
Autonomous consumption expenditure
Autonomous investment spending
Government purchases
Taxes
Autonomous net exports
Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction

14. Shifts in the AD Curve From Shifts in the IS Curve

15. Factors that Shift the Aggregate Demand Curve (cont’d)
Shifts in the MP curve
an autonomous tightening of monetary policy, that is a rise in real interest rate at any given inflation rate, shifts the aggregate demand curve to the left
similarly, an autonomous easing of monetary policy shifts the aggregate demand curve to the right

16. Shifts in the AD Curve from Autonomous Monetary Policy Tightening